Analysis on Trading Psychology & The Sunk Cost Fallacy – Guest Editorial
You’re out with your friends, and they order a big bottle of vodka. The cost will be divided equally between the attendees, no matter how much each party consumes – This is the ‘sunk cost fallacy’ as EverFX looks at how this relates to trading psychology
The management team at EverFX looks at important psychological considerations that play a major part in trading the markets.
Changing your mind might be the most underrated trading skill.
Adapting, pivoting, changing course, and altering your strategy halfway through execution are all qualities that can come in handy when trading. Being able to maneuver in the face of new information is an art, a powerful weapon that can save you time and, most importantly, money.
It sounds simple. When things go south when the market behaves irrationally and when your original strategy goes wrong, you recuperate, adjust and calibrate your strategy to fit the new data.
If only the human brain worked that way.
Unfortunately, people tend to marry their ideas and keep going down the same road even when things are not going according to plan. This phenomenon does not just apply to trade rules, but it’s a trend that can be found in all walks of life.
Sunk Cost in Real Life
Think of all the times you insisted on making friendship or romantic relationship work. The amount of time and effort you invested in trying to fix something that was broken. The signs came in all shapes, forms, and frequencies but you chose to look the other way: fights, arguments, disagreements, nights where you cried yourself to sleep.
The increasing negative feelings of committing to that choice should have made you change your tune and disengage, yet the more things turned sour, the more you seemed to hold on for dear life.
If that example doesn’t ring a bell, maybe this one will. You’re out with your friends, and they order a big bottle of vodka. The cost will be divided equally between the attendees, no matter how much each party consumes. Even though you’re not feeling like drinking, you force yourself to do so just because you’ve paid.
Still not convinced? What about that New Year’s resolution? The pottery class you hated from the very first minute you put your fingers on wet clay but kept on going back just because it was what you promised yourself, you’d do. Stuck with an experience you clearly knew was not offering you any value but for some reason, did not have the mental strength to pull the plug and move on.
This behavioral pattern has a name, and it’s referred to as the sunk cost fallacy or the escalation of commitment. This occurrence relates to the inability of human beings to make rational decisions based on the events that are happening right in front of their eyes. The main drivers behind this behavior are ego and the need to be proven right which brings us back to trading.
Logic dictates that when making trading decisions, the sole goal of all-day traders would be to secure a winning trade. While that’s mostly the case, there’s something to be said about the pleasure, satisfaction, and gratification derived from being right.
The feeling that you somehow managed to foresee and accurately predict how financial markets will behave, react and fluctuate. That your idea, your strategy, and plan were spot on from the get-go. But if you use the analytics system from EverFX, or Investing.com then you can reduce the risks.
So, what are you suggesting? Admit I was wrong?
That’s precisely what you need to do. Admit that what you thought was right is not and cut your losses by changing strategy. The sunk cost effect implies that you need to accept the fact that the cost has already been incurred, cannot be recovered, and there’s nothing you can do to salvage it by continuing down the same road.
Going back to our examples, the best course of action for each scenario would have been to exit the toxic relationship, not drink on the night out despite having already paid and quit the pottery class since it’s making you so unhappy.
Being wrong is not a hit or judgement or intellect. When making those decisions or coming up with those plans, you had a certain amount of information and data. Things change, though, and so should opinions and strategies.
Surely, you invested time and effort and money going down this specific road, but if that road means you’re losing trades then it would be wise to reconsider.
Since parallelisms are the theme of today’s post, let’s use another one. Imagine you’re building a house, and three months into it, you realize there’s a mistake in the foundation. The error is so significant that there’s the possibility the house will collapse at one point in time.
What do you do? Do you keep going just because you’ve already been working on this project for three months? Do you neglect the risk and danger associated with your decision? What you need to do is obvious. Tear it all down and start all over again.
Move on But Never Forget
Moving on and assuming the cost of a decision does not mean there’s nothing to learn from the experience. As the great American basketball coach John Wooden once said: “It’s what you learn after you know it all that counts.”
The ability to think on your feet, process the new information that has presented itself, and enable your emotional intelligence to decide to change course are all signs of a successful trader, someone who doesn’t like losing money and thinks long term.
Each time you face a sunk cost scenario, you are faced with an opportunity to learn and use that knowledge to your advantage in the future. Adjusting your position will add experience to your decision-making process, making your trading plans more informed and technically sound.
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